RIIO2: how low will it go?

Amid criticism that the energy networks are making billions in “unjustified profits”, regulator Ofgem has warned that its next price review period – RIIO2 – will be tougher. But how low will the cost of capital go?

The starting gun has now been fired on the second round of the RIIO price controls, as last week Ofgem published an open letter to stakeholders seeking views on how the framework should evolve to adapt to the fast-changing energy environment.

The letter set out an array of potential reforms which the regulator is considering, many of which have been called for by energy networks themselves. However, it also came with a warning that the next price controls will be “tougher” – something they will be less pleased to hear.

As part of this pledge, Ofgem will review the way in which it sets the allowed cost of capital for energy networks – a key component of company returns. According to the letter, the current market condition for both debt and equity financing have “diverged significantly from expectations at the time the cost of capital for RIIO-1 was set”.

“At the same time, we have seen investors willing to buy regulated assets at high premia to the regulated asset values, suggesting a willingness to accept long-term yields considerably lower than the cost of capital set for RIIO-1,” the letter adds. It was largely on this basis that Citizens Advice concluded that energy networks are line to receive £7.5 billion in “unjustified profits”.

EY head of power and utilities economic advisory Anthony Legg says the signal from Ofgem does not come as a great surprise: “The question is how much lower, and Ofgem didn’t say much about that specifically in the document.”

The letter did, however, point to water regulator Ofwat’s preliminary estimates for the cost of capital for the PR19 price controls for the water sector as an example of what can be expected for energy networks. A consultation published by Ofwat earlier in the week, warned water companies to expect a “significant reduction” in the weighted average cost of capital (WACC). The water regulator cited research from PwC last month which suggested that the cost of equity – if it were set on the same RPI-linked basis as at PR14 – would be 3.8-4.5 per cent at PR19, “quite a step down” from the PR14 number of 5.65 per cent. By comparison the cost of equity for the ED-1 price controls is currently 6 per cent for all but one of the electricity distribution networks.

“I think Ofwat’s numbers were a little bit lower than people were expecting,” says Legg. “I would imagine people are looking at Ofgem’s reference to Ofwat in a similar kind of light.”

The debt portion of the WACC is indexed to a rolling average of historic market costs, typically covering the previous ten years. The equity portion is not – something which Ofgem says it may change.

Citizens Advice argues it should, claiming that the failure to index the equity segment to real market data has by itself left consumers overpaying by £3.4 billion. According to the charity, market prices are “always going to be a better, less biased guide to actual costs than long-term regulatory forecasts.” It also says that period of historic data used to index debt costs should be shortened to make the WACC more responsive to market developments.

Mike Huggins, director of Frontier Economic’s energy practice, believes Ofgem should take a cautious approach when considering such changes. “Long standing UK regulatory practice has been to set allowed equity returns by reference to long run averages. That has great benefits in terms of simplicity, transparency and stability.

“But if long run averages are used, inevitably there will be periods when spot rates are below the long run average, as seems to be the case now. The question of whether it is now right to abandon the long run approach is complicated and requires careful analysis, to explore whether short run benefits may create long-term costs.”

Ofgem has also signalled its intention to get tougher on the allocation of spending allowances.

Under the current arrangements, networks can be fast-tracked through the settlement process if Ofgem is satisfied with their initial business plans. They are rewarded with lower “sharing factor”, meaning they get to keep a greater proportion of any underspend against their allowance.

“There is also an alternative and plausible complementary explanation for outperformance”

Mike Huggins, director of Frontier Economic’s energy practice

Those which are slow-tracked are obliged to submit revised business plans and are allocated a sharing factor based on their divergence from the information quality incentives benchmark – a composite of Ofgem’s own cost estimates and the aggregated business plans of the slow-tracked networks.

However, Helen Poulter, a researcher from the Exeter Energy Policy Group, told Utility Week recently that the system does not provide sufficient incentives for networks to submit accurate business plans and has thereby enabled them to “game the system” – a view shared by Citizens Advice.

Ofgem itself concedes the current process isn’t perfect. “We recognise we can improve the way we evaluate the companies’ business plans,” wrote senior partner for networks Jonathan Brearley, in the letter. “We want to set expectations up front about the economic and efficient costs of running the networks based on previous price control information and other benchmarking.”

According to Huggins, this suggests that Ofgem believes the allowances were set too high and that “a wide range of mechanisms did not work well at RIIO-1”. However, he adds that this “negative interpretation of cost outperformance” is not the only way of look at things.

“There is also an alternative and plausible complementary explanation for outperformance. Ofgem has put in place strong incentives to encourage cost outperformance, so perhaps shouldn’t be surprised when such outperformance subsequently appears.” He said the underspends achieved by networks could in fact be “evidence of the success, not the failure, of its high-powered incentive arrangements.”

Maxine Frerk, director at Grid Edge Policy, says cost setting has “always been a problem” for regulators: “I think what we’ve got now is more transparent, which is probably a good thing, but it does put things in the spotlight a bit more.”

Frerk disputes the suggestion that some networks may have been tempted to deliberately forgo being fast-tracked in a bid to secure higher allowances. She claims the “big rewards on the table” have been successful in luring networks down the fast-track route and ending the old “game” between the company and regulator to “see how much they could get away with”.

Millhouse Power director Dave Openshaw says the accelerating pace of change in the sector means forecasting costs in advance will become “ever more difficult” in future for both networks and Ofgem. “Therefore, do you need a more flexible, agile form regulation that adapts on an annual basis to what is actually materialising.”

Up until now networks’ profits have largely escaped the national media scrutiny placed on the earnings of suppliers. This is unlikely to continue in the future given networks’ growing importance to the transformation of the energy system and the increased political consciousness around living costs.

If Ofgem wants to shield itself from the same headaches it has faced in the retail sphere, it will need to do everything it can to reinforce the legitimacy of the RIIO settlement procedure. What exactly this entails is clearly open to debate, but the willingness the regulator has shown to tackle critics’ concerns head on is a positive sign for things to come.